As we have entered the start of the new year, the US stock market has continued to climb to record heights. The market is, in some ways, highly rated and the most expensive if we compare it to its history. And while there is a fair amount of excitement around some companies and sectors at the moment, that doesn’t necessarily mean we are in a bubble.
Instead, the decline in interest rates since the 1980s, together with the low inflation that we have seen for a while, could both explain and justify the market’s higher rating. And this could also be part of the reason the US market has performed so well since the Financial Crisis.
The idea we are in a bubble comes from a few places:
- Stocks have had a good run for a little over a decade now. Since just after the Financial Crisis, the US stock market has returned more than 500% including dividends.
- The US market currently trades on a cyclically adjusted PE ratio well above its long run average, even though the real economy has suffered one of the biggest shocks on record.
- An over-optimistic view of the US stock market from investors.
What we have seen is that it is not a broad valuation bubble across the whole US market, but instead one that has been driven by sectors, as areas like tech have been overdone but financials are still seen as undervalued. But even if the US stock market isn’t in a bubble, there are still risks as bubbles tend to make people nervous because they have a habit of bursting. You do need to look at the risks carefully though.
If a company’s profits vary from year to year, a normal PE ratio (a company’s share price divided by its earnings or profits) can be misleading as profits could be unusually and unsustainably high or low. When looking at the S&P 500 for example, profits at lots of companies were a lot lower in 2020 because of the coronavirus pandemic. A PE ratio for the market could therefore be misleading if investors expect those profits to recover.
Instead, a Cyclically Adjusted PE (also known as the Shiller PE ratio) divides the price of the index by the average of its earnings in the last ten years, all adjusted for inflation. That way, ups and downs in earnings are smoothed out to give a less jumpy picture of the market’s valuation.
Using this ratio instead shows the US stock market has only been this highly valued twice before. Once was during the Dot Com Bubble in the late 1990s, and then before the 1929 market crash signalling the beginning of the Great Depression. Charts like this make people very nervous, mainly because they believe that the market is likely to revert to its long run average.
However, interest rates have also fallen by a lot in the last few decades and have been at historical lows for the last 10 years. This has important implications for valuations as, all things being equal, falling interest rates increase investment values. And in the bond markets, central banks have unlimited resources with stimulus to continue to support low interest rates for longer.
As interest rates have fallen, we should expect stock markets to trade at a higher level. When looking at other valuation measures, the market doesn’t look overvalued. This doesn’t mean individual companies aren’t over or undervalued though, some might well be. It’s also not to say stock markets can’t fall from here, they definitely could. Companies might not grow as fast as people think, or expectations of how much money they will make in the future could also change. If so, the share price would fall. Similarly, if interest rates rose the market is also likely to fall. Once again, portfolio diversification remains key.